UK inflation: Why this is good deflation

Falling petrol prices have helped drag the UK into deflation, but that is no bad thingReuters

Deflation can cause concern. And for the second time in a year, the UK economy has slipped into deflation. But it is nothing to worry about. This is good deflation, not bad.

According to the Office for National Statistics (ONS), the Consumer Price Index (CPI) measure of inflation fell by 0.1% in the year to September 2015. That means that the cost of a basket of goods is cheaper than it was before because prices are falling. The key difference between good and bad deflation is the reason prices are falling.

Deflation is bad when it is the result of less money in the economy, meaning consumers are buying fewer products and services and firms are slashing prices in a bid to stimulate demand. This can lead to worsening company performances, potentially sparking cost cutting, such as redundancies. Less spending means lower demand which hurts economic growth.

Worse still is the potential for a deflationary spiral – where people hold on to their money rather than spend it because they think it will be worth more in the future. This saps more demand from the economy, in turn pushing prices down further, so people hang on to their money for longer. Breaking this spiral is a big challenge for central bankers.

But we do not have to worry about that (yet). Here is why the UK is experiencing good deflation.

Falling commodity prices, such as oil, are causing deflation

A glut in the supply of oil has driven down its price. This has had a knock-on positive effect on most businesses, who face lower costs. In the retail sector in particular, prices are lower because goods are cheaper to manufacture and transport. And at the pumps, lower petrol prices have eased the pressure on drivers' wallets. Many commodity prices have fallen, from oil to agricultural produce to metals. Often, these lower prices are passed on to the consumer -- which pulls down the headline CPI reading. Michael Martins, economic analyst at the Institute of Directors, said:

There will be plenty of people ready to celebrate another month of rock-bottom inflation. Falling food and fuel prices have boosted the spending power of households across the country and businesses can spend less on moving goods and people across the world and more on paying down debt, investing in equipment, hiring staff or offering pay rises. This has led to impressive pay growth and productivity gains in the private sector after years of stagnation and should see business investment continue to grow.

Real wage growth is stronger

For much of 2015, CPI inflation has been at or very close to 0%. At the same time, wage growth excluding bonuses, rose to 2.9% over the year, according to the ONS. In recent years, wages have been in decline because they grew more slowly than prices – so this is a welcome reversal. Higher wages, lower prices.

Consumers are still spending money

If consumers were not spending, we would be worried. But amid record high employment levels and wage increases, consumer spending is on the rise while the household savings ratio is falling. There is no hoarding going on.

Inflation has been stable and is set to rise soon

As a note from Investec Economics put it: "The headline inflation rate has remained remarkably stable in recent months: today's data marks the eighth month running where the headline inflation rate has remained fairly steady within the -0.1% to +0.1% range. During this period, we have not seen a worrying dislodging in inflation expectations."

And in the coming months, it will creep back up. Sharp falls in oil and food prices will soon drop out of the calculations and higher wages will pull shop prices back up. Investec and the Centre for Economics and Business Research (CEBR) predict 1% inflation again before 2015 is out.

It gives the Bank of England breathing space on interest rates

Policymakers at the Bank of England are juggling when best to raise the base rate from its all-time low of 0.5% as the economy recovers from the financial crisis. This is to stop people gorging on cheap credit in a booming economy, which would carry substantial financial risks. But the Bank of England must target a 2% inflation rate over the medium term. So if it raises interest rates, it will cost more to borrow money – so less of it will make its way into the economy.

This puts a downward pressure on prices because people have less money to spend. It also puts the recovery at risk because a premature hike in rates could harm economic growth. It is a finely balanced decision. But while inflation is temporarily low, central bankers are under slightly less pressure to bring interest rates back up to more normal levels. Rob Harbron, managing economist at CEBR, said:

Although 'no-flation' may be starting to feel like it's here to stay, CEBR expects price growth to pick up in the next few months [...] However, even despite this pick-up, inflation over the year as a whole is likely to stand at around 0.2%. This is the lowest since comparable consumer price data began, and gives the Monetary Policy Committee at the Bank of England scope to maintain rates at their emergency low of 0.5% for longer. Nevertheless, price pressures will begin to creep in next year – not least from the introduction of the national living wage – and the time to start tightening monetary policy grows closer. Expect the first rate rise in Q2 next year.

Which gives the wider economy breathing space on interest rates

Most of us have debt in some form or other. Mortgages, car finance, personal loans, credit cards and so on. So do businesses. When interest rates rise, our repayment costs on this debt will also go up, taking up more of our incomes and leaving us with less to spend or save. Any delay in the rise to interest rates gives us a chance to utilise the cheap credit environment by refinancing our existing debt, or saving more to cope with the increase when it does come. Or even by paying off more of it now while rates are low.